What is the US fiscal cliff?

With the US presidential election finally decided, President Barack Obama and Congress must quickly turn their attention to the pending "fiscal cliff" if they want to prevent the country falling back into recession.

The fiscal cliff, a term coined by US Federal Reserve chairman Ben Bernanke, is used to describe a raft of tax increases and spending cuts that will automatically come into effect at the beginning of 2013 if the Democrats and Republicans cannot negotiate a new set of budgetary and economic policies to reduce the spiralling budget deficit of US$1.1 trillion (NZ$1.3t).

The fear is that if President Obama can't find a way through the problem, the revival in the US economy may stall, plunging the nation back into recession.

But the problem facing the newly re-elected president is twofold. There is the economics, and then there is the politics. In order to keep the US from falling off the fiscal cliff, Obama - a Democrat - must negotiate an agreement with Republicans, who have different ideas about how the budget should be brought back into line.

These are the main measures.

Tax increases

  • The expiration of a 2 per cent payroll tax cut, most likely to affect the average American worker
  •  End of the Bush-era tax breaks, which lowered incomes taxes for all Americans as well as taxes on capital gains and dividends
  • The Tax Policy Office, a non-partisan research group, said as a result US households on average would pay almost US$3500 extra tax per year. For middle income households the number would be closer to US$2000, or around 4 per cent of pre-tax income.

Spending cuts

  • Automatic spending cuts, including a US$55 billion reduction in defence spending and a US$55b cut to domestic spending in 2013 and subsequent annual reductions in that volume until 2021.
  • Cuts to unemployment social security and unemployment benefits totalling US$26b.
  • A reduction in payments doctors receive for participating in Medicare of US$11b.

1. The US Congressional Budget Office (CBO) estimates the combination of all tax increases and spending cuts would result in the deficit falling to US$641b in the 2013 fiscal year (ends September 30), but the savings would result in a recession, with GDP shrinking by 0.5 per cent and a rise in the unemployment to 9.1 per cent  by the end of 2013, from 7.9 per cent in October. However, the CBO projects GDP to return to growth after 2013 and the unemployment rate to gradually ease to 5.7 per cent by the end of 2017.

2. If the US government were to continue down its current road, with a deal being struck to keep all current measures in place, the country’s deficit is forecast to hit US$8.8t by 2022. This does little to help the US as its debt and servicing costs become too high and it defaults on its loans.

3. Finally policy makers could come to some sort of compromise that would address the country's spiralling debt but to a lesser extent. This would likely result in a slowing growth and rise in unemployment but not as severe as option 1.